Excess Pressure.

Special Report: Aggressive pricing and commercial lines deregulation are changing the face of the excess and surplus lines market.

The excess and surplus lines, or nonadmitted, market is comprised of property and casualty companies that provide insurance that is unavailable to businesses in the standard, or admitted, market due to the unique characteristics and needs of the consumers. As a result, the surplus lines market is known for developing new and creative types of coverage--such as e-commerce products that provide coverage for damage caused by computer viruses or hackers. Without the surplus lines market, businesses would have to forgo traditional insurance, self-insure their exposures or search for coverage outside the U.S. market.

Beginning in the late 1980s, the surplus lines segment became a more established market, despite soft market conditions and the excess availability of capital. Leading factors that contributed to the greater importance of the E&S market included underwriting actions by large standard carriers to shed noncore books of business; increased frequency and severity of weather-related claims, which resulted in a reduction in capacity for property coverage in catastrophe-prone areas; continuing legal and regulatory issues that have resulted in difficult underwriting environment for standard carriers operating in certain locations; and expanding expertise and market position of many surplus lines companies in difficult niche markets.

Meanwhile, the surplus lines market has had to adapt to intense competitive-market pressures, such as aggressive pricing and coverage expansion offered by standard carriers to preserve market share; market encroachment by standard carriers that write more surplus lines risks on an admitted basis; greater appeal of the alternative market as self-insured entities attract and retain potential surplus lines business; and widening commercial lines deregulation as more states exempt "sophisticated" commercial insurance buyers from burdensome rate- and/or form-filing requirements.

At year-end 1999, direct premium volume for the surplus lines industry increased by nearly 8%.

This increase reflects primarily the migration of business rises from the standard market into the surplus lines market. This compares favorably to the anemic 3.2% growth experienced by the property/casualty industry in 1999.

While several niche surplus lines companies have been successful, this market is increasingly dominated by larger carriers. Size and flight to quality trends have benefited the large surplus lines carriers, with the top 25 groups commanding an 80% share of the market. Going forward, A.M. Best believes that many midsize surplus lines carriers will align with larger diversified organizations that provide greater operating and financial flexibility. Struggling carriers are more susceptible to tougher regulatory requirements and fierce price competition because their business tends to be concentrated in a particular distribution system or product mix.

A.M. Best believes successful companies will focus on customized products and services in today's competitive environment. Offering valuable risk-and claim-management services can combat the tendencies of policyholders to gravitate to the cheaper admitted market. Further, companies that have strong underwriting expertise and broader product offerings can leverage their distribution channels more effectively to find new growth opportunities. Best-of-breed insurers will leverage technology and employ data-mining techniques to target and retain their customers. Although the insurance buyers purchase through intermediaries, even the E&S segment is being forced to expand customers' channel options to the Internet to remain competitive, reduce costs and allow agents to focus more on value-added services and less on administrative tasks.

Strong Financial Condition

The surplus lines market historically has been viewed in a somewhat negative light by the public and the insurance industry, which have questioned the financial security of this less regulated segment of the market. But A.M. Best's analysis of this market segment refutes this misperception. Our review of the financial condition of the surplus lines market is based on a composite of domestic professional surplus lines companies.

We have developed a composite of 67 companies that had direct premium volume of $4.6 billion at year-end 1999, which represents 43.4% of the total surplus lines market.

Over the past five years, the underwriting performance of the surplus lines market has continued to outperform the property/casualty industry by 9 points. Its favorable underwriting results are due to its disciplined underwriting approach, solid underwriting expertise and strong risk-management techniques. Underwriting results also have benefited from the release of prior-year loss reserves.

Prolonged soft market conditions have eroded loss reserve margins. While A.M. Best believes that the loss reserve position of the surplus lines composite remains strong, future underwriting results are not expected to benefit significantly from the release of prior year loss reserves. The overall performance of the composite has remained outstanding, evidenced by a five-year pretax and total return on revenue of 27.7% and 25.5%, respectively.

The composite also has generated steady investment earnings growth over the past five years, despite prevailing low interest rates. Since 1995, the composite's investment income has increased 23%, vs. 15% for the property/casualty industry. The higher growth rate is principally due to the fact that the composite maintains a greater percentage of assets that are invested in fixed-income securities than that of the property/casualty industry.

An indicator of the intense market conditions is the weakening cash-flow position of the composite. While operating and total net cash flows remain slightly favorable, underwriting performance has weakened, producing negative cash flows in 1998 and 1999. Despite the deterioration, overall liquidity measures remain strong, and the quality of the investment portfolio remains very conservative.

The surplus lines composite historically has maintained a lower level of premium and reserve leverage than that of the property/casualty industry. This is largely attributable to:

* insureds' demand for greater financial security, due to the lack of guaranty fund protection in virtually all states;

* modest premium growth from soft market conditions; and

* the need for excess capacity to quickly respond to opportunities in the market.

The surplus lines composite maintained net premium leverage and net underwriting leverage of 0.5 and 1.8, respectively, vs. 0.9 and 2.5 for the property/casualty industry, at yearend 1999.

But on a gross basis, the surplus lines composite maintains underwriting leverage that is slightly higher than that of the industry. This is not unexpected, given the higher liability limits provided by the surplus lines carriers and the greater catastrophe exposures associated with their property book of business, which would require greater reinsurance to protect the balance sheet.

During 1999 and 2000, specialty risks that had been insured by the standard market began to migrate back into the surplus lines market, as many standard market insurers refocused on their core operations. This migration also is attributed to tightening in the reinsurance market.

In the near term, A.M. Best expects that the surplus lines market will benefit from the re-underwriting initiatives being taken by the standard market. This should have a favorable impact on the E&S market's operating performance as well as its balance-sheet strength.

Best's Ratings, Solvency Trends

Consistent with prior years, most professional surplus lines companies have maintained higher ratings than that of the property/casualty industry. The median Best's Rating for the professional surplus lines composite remains A (Excellent) vs. the industry's median rating of A- (Excellent). A.M. Best attributes the more favorable ratings to four factors:

* demands of the market that surplus lines carriers maintain a higher level of capital, due to their lack of guaranty fund protection in virtually all states;

* surplus lines writers tend to operate with more conservative operating leverage with sidelined capital waiting to take advantage of market opportunities;

* more disciplined underwriting coupled with strong risk-management techniques that have consistently produced favorable loss experience; and

* a majority of the leading surplus lines writers are strategic members of large well-diversified insurance organizations.

Since 1971, surplus lines company insolvency rates have mirrored those of traditional insurers, with an average failure frequency rate less than 1%. The similarity of failure frequency rates attests to the pricing discipline of the surplus lines market, particularly considering the lack of rate regulation. Since 1992, insolvency rates for the property/casualty industry have generally stabilized. A.M. Best attributes this trend, in part, to competition in the market, which has encouraged healthy insurers to rescue ailing insurers before they became insolvent.

Modest surplus size is the leading characteristic of the nearly 50 identified surplus lines insolvencies since 1971. Of the insolvent surplus lines companies, 92% maintained surplus of less than $25 million and one-half had surplus less than $5 million. A.M. Best has been able to identify the primary cause for three-quarters of the surplus lines insolvencies, while the balance consisted of companies whose insolvency was unidentifiable or attributable to multiple causes. The leading causes of insolvency were identified as deficient loss reserves and rapid uncontrolled growth.

Commercial Lines Deregulation

Commercial lines deregulation is an effort to remove unnecessary or ineffective regulation from transactions that are deemed to be self-regulated. As of the end of July, commercial lines deregulation had been enacted in 20 states and defeated in only four states (Connecticut, New York, North Dakota and Texas). The intent of commercial lines deregulation has been to remove unnecessary and ineffective insurance regulation from transactions pertaining to sophisticated and/or large commercial policyholders.

The industry believes that deregulation is needed to enable commercial lines insurers to compete effectively and respond efficiently to their customers' ever-changing needs. Deregulation is considered crucial to maintaining a level playing field with banks and securities firms, due to the passage of the Financial Services Modernization Act.

On the other hand, the surplus lines community contends that an efficient deregulated national market already exists through the nonadmitted mechanism. The surplus lines community argues that if the admitted market is deregulated, however, then the surplus lines market also should be deregulated, so that exempt commercial insurance consumers can benefit from a competitive marketplace.

A.M. Best believes that deregulation will intensify competition in the surplus lines market. In the near term, this will only depress rates further and weaken the financial condition of some insurers. This concern is largely mitigated, however, since most surplus lines insurers are now affiliated with larger groups. These affiliations enhance the ability of these carriers to compete more effectively with specialty admitted insurers.

The lack of uniformity among states regarding deregulation is a major concern of A.M. Best, as too much emphasis is being placed on premium size in determining a sophisticated buyer. The lack of uniform qualification requirements raises additional issues for insureds that maintain multistate operations. Further, the lower minimum capital requirements for admitted companies provides additional concern, since a majority of the surplus lines insolvencies impacted carriers with less than $5 million in surplus.

Overall, A.M. Best is supportive of deregulation initiatives designed to promote a healthy and efficient market and encourages legislation that fairly addresses all affected parties. The flexibility these initiatives are intended to provide insurers, and consequently to the benefit of policyholders, are viewed positively. However, the challenge for regulators is ensuring that tins movement does not overly disadvantage any of the current markets.

Mergers and Acquisitions

Over the past couple of years, consolidation trends within the property! casualty industry have finally taken hold, evidenced by a decline in the number of domestic organizations that were letter rated by A.M. Best. A.M. Best predicts that roughly one-third of the 1,100 property/casualty insurance groups--particularly smaller insurers that lack operating scale, spread of risk, and financial flexibility--are at risk of losing their operating autonomy or withdrawing from the market within the next five years.

A.M. Best believes that the property/casualty industry is in the midst of three overlapping phases of consolidation that vary by discrete market segments:

* Financial Consolidation (Phase 1): characterized by weak competitors falling victim to tougher market conditions and more formidable competitors.

* Strategic Consolidation (Phase II): characterized by strong local and regional personal and standard commercial carriers merging in an effort to gain greater operating scale and improved efficiencies.

* Cross-Sector Consolidation (Phase UT): characterized by industry consolidation involving noninsurers--like banks and security firms that acquire or merge with insurance companies.

In contrast, A.M. Best expects surplus lines consolidation activity over the next five years to be modest compared with the overall property/casualty industry, since a substantial portion of market participants are now members of large diversified organizations.

A.M. Best anticipates, however, a greater number of strategic consolidations, whereby midsize surplus lines groups are acquired by or merge with midsize standard market insurers or reinsurers. Surplus lines insurers continue to provide solid investment and strategic opportunities for standard market insurers and reinsurers as these combinations offer product and earnings diversification.

Market Cycles

Today, there is growing evidence that suggests that the market has begun to firm. Several insurance company CEOs have stated publicly that their organizations are eliminating noncore books of business, strengthening underwriting guidelines and raising rates. As comments materialize into consistent actions at the field level, A.M. Best expects to see the continued migration of specialty risks back to the surplus lines market.

Based on interviews conducted by A.M. Best of surplus lines underwriters and brokers, the migration of business from the standard market began taking place in 1999 and has continued through the first half of 2000. Further information compiled by the stamping offices supports the view that business underwritten by the standard market in recent years is being reunderwritten and is selectively moving back to the surplus lines market. Stamping offices operating in 15 states provide some regulation for E&S insurers by performing financial reviews, verifying declinations and monitoring the market.

The migration of business is largely attributed to a reduction in capacity from the standard market, combined with increasing pressure from reinsurers. Over the past 18 months, there has been a material contraction of capacity from the standard market to underwrite specialty classes of business.

In recent years, casualty loss costs have increased, due primarily to rising legal and medical costs. But as business moves into the surplus lines market, the increased loss costs are expected to be offset by more favorable rate activity. A.M. Best believes that the market cycle within the surplus lines market is on an upswing, albeit much less pronounced than the mid-1980s, which will be followed by greater premium volume and more robust operating margins.

A.M. Best's annual studies have validated that the surplus lines market maintains financial performance and solvency rates that are on par with the admitted market. Despite lingering negative perceptions from the past, surplus lines carriers have proven to be a viable and successful market segment.

The role of state regulators and independent rating agencies, such as A.M. Best, remains important, particularly in the absence of federal regulation. A.M. Best continues to provide financial-strength ratings and discerning information to assist brokers and insureds in identifying financially credible companies.

In conclusion, A.M. Best believes the following recommendations should be considered by lawmakers, policy makers, regulators, and industry executives:

* Consistency of regulation: Establish consistent eligibility requirements from state to state. This could easily be accomplished by the adoption of minimum surplus standards outlined in the Nonadmitted Insurance Model Act, passed by the NAIC in 1994. Many states have or are working toward a minimum surplus requirement of $15 million for surplus lines companies. Additionally, we encourage states that have not yet done so to create a stamping office.

* Stiffer punishment and fines: Stronger and more effective laws should be passed by state and federal legislatures that would more severely penalize insurance management companies (domestic or alien) and brokers who operate illegally or with gross negligence.

* Greater access to information: Information that enhances the industry's ability to detect problematic brokers or companies should be made more readily available by state insurance departments, the NAIC and other insurance-related entities. A.M. Best believes that the lists such as die California Unacceptable Nonadmitted Carrier List; the LID Alien Insurer, or "White list"; and the black lists generated by many states should be distributed more widely.